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Making Sense of Profits Using Profitability Ratios

Making Sense Of Profits Using Profitability Ratios Splash image

Long-term investors buy shares of a company with the expectation that the company will produce a growing future stream of cash or earnings.

Profits point to the company’s long-term growth and staying power.

But “more” profits aren’t necessarily better than “less.” Oil companies have been in the headlines for generating “record profits” that are larger than any other firms in U.S. history. But from an investor’s standpoint, that doesn’t necessarily make them the most profitable firms.

That’s because profit figures are absolute numbers—they are simply a firm’s revenues less its costs. They don’t relate profits to the size of the company in terms of sales, its total resources or the amount of money investors have put into the company.

How can you put the numbers into context?

There are a number of financial ratios that help to measure the profitability of a firm.

Profits Relative to Sales

One way to measure the profitability of a firm is to relate a firm’s profits to its total sales. That is done using profit margin ratios. All of the figures used in these calculations can be found in a firm’s income statement.

Gross profit margin is calculated by dividing gross income (sales less the cost of goods sold) by sales revenue. It reflects the firm’s basic pricing decisions and its material costs. The greater the margin and the more stable the margin over time, the greater the company’s expected profitability. Trends generally signal changes in market competition.

Operating profit margin is calculated by dividing operating income by sales. Operating income, or earnings before interest and taxes (EBIT), represents income generated after all costs except interest, taxes, and non-operating costs.

The operating profit margin examines the relationship between sales and management-controlled costs (the cost of goods sold, as well as operating costs including selling, administrative and general expenses; research and development expenses; and depreciation) and management-controlled operating efficiency. It does not consider the effects of how the firm is financed, or the contribution (or drag) of non-business activities. As with the gross profit margin, investors should be looking for a high, stable margin.

Net profit margin is calculated by dividing net income by sales. Net income is operating income less non-operating expenses (including interest paid by the firm on outstanding debt and other related financing costs) and less taxes.

Net profit margin is the “bottom line” margin frequently quoted for companies. It indicates how well management has been able to turn revenues into earnings available for shareholders.

Industry comparisons are critical for all of these profitability ratios. Margins vary from industry to industry. A high margin relative to an industry norm may point to a company with a competitive advantage over its competitors.

Profits Relative to Assets

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Another way to measure profitability is to relate a firm’s profits to the total resources a firm has available to it.

Return on total assets (ROA) is calculated by dividing net income (sales less all costs and taxes) by the total assets of a firm. The total assets of a firm are all of its resources available to generate earnings, including: current assets (cash, accounts receivable, inventory); property, plant and equipment; and other assets such as goodwill. The total assets figure appears on the firm’s balance sheet.

ROA measures how well management is using all of the resources of the firm. A high return implies the assets are productive and well-managed.

Profits Relative to Dollars Invested

Profitability can also be measured by relating profits to invested dollars.

Return on stockholders’ equity (ROE) is calculated by dividing net income (sales after all costs and taxes) by stockholders’ equity (also known as book value, or net worth). Stockholders’ equity, which appears in a firm’s balance sheet, represents investors’ ownership interest in the company, and consists of all common stock (the amount investors have put into the firm), along with retained earnings. Retained earnings are the accumulation of earnings, after all expenses and dividend payments have been made; they represent the reinvestment of earnings into the firm.

ROE indicates how much the stockholders earned for each dollar they have invested in the company. However, the level of debt (financial leverage) on the balance sheet has a large impact on this ratio. Debt magnifies the impact of earnings on ROE during both good and bad years. When large differences between return on total assets and ROE exist, you should closely examine the amount of debt the firm has employed.

Making Sense of Profits

If you are a long-term investor, profit figures alone won’t tell you much about a company. To be useful, they need to be put into context. Profitability ratios allow you to do this:

  • If you want to measure the return a company is generating from its line of business, how it finances its business, and its tax structure, you would turn to profit margin ratios.
  • If you want to measure the return a corporation is generating from its own assets, you would determine the firm’s return on total assets (ROA).
  • If you want to measure the return shareholders are getting from their invested dollars, you would determine a firm’s return on shareholders’ equity (ROE).

Table 1 provides the equations for calculating these profitability ratios, along with examples.

Table 2 provides definitions for the terms used in the calculations.

Table 1. Profitability Ratios: An Example

From the Income Statement:
Sales Revenue: $8,500
Gross Income: $2,900
Operating Income (EBIT): $750
Net Income: $380

From the Balance Sheet:
Total Assets: $4,150Stockholders’ Equity: $1,700

How the Ratios Are Calculated

Gross Profit Margin = Gross Income
Sales Revenue
= $2,900
$8,500
= 34.1%

 

Operating Profit Margin = Operating Income (EBIT)
Sales Revenue
= $750
$8,500
= 8.8%

 

Net Profit Margin = Net Income
Sales Revenue
= $380
$8,500
= 4.5%

 

Return on Assets = Net Income
Total Assets
= $380
$4,150
= 9.2%

 

Return on Stockholders’ Equity = Net Income
Stockholders’ Equity
= $380
$1,700
= 22.4%

Table 2. Definition of Terms

From the Income Statement

Sales Revenue: Total sales for the period.

Gross Income (Gross Profit): Sales revenue less cost of goods sold (includes raw materials and labor costs to create the finished product).

Operating Income, or Earnings Before Interest and Taxes (EBIT): Gross income after all operating costs (including selling, administrative and general expenses, research and development expenses, and depreciation), but before interest, taxes, and non-operating costs.

Net Income: Operating income less non-operating expenses (including interest paid by the firm on outstanding debt and other related financing costs) and less taxes.

From the Balance Sheet

Total Assets: All of the assets of a firm, including current assets (cash, accounts receivable, inventory); property, plant and equipment; and other assets such as goodwill.

Common Stockholders’ Equity (Net Worth, Book Value): The total assets of the firm less all debt and other liabilities of the firm. It represents investors’ ownership interest in the company, and consists of all common stock (the amount investors have put into the firm), along with retained earnings. Retained earnings are the accumulation of earnings, after all expenses and dividend payments have been made; they represent the reinvestment of earnings into the firm.

 

More on AAII.com

For further information on understanding the figures in a company’s financial statements and how to use the ratios derived from them, see the following series of articles in the Investor Classroom area of AAII.com:

Digging for Gold: What the Financial Statements Reveal About a Firm


Discussion

David Fox from NM posted about 1 year ago:

Then there is ROIC--Return on Invested Capital which Elizabeth Collins, in a 10-27-05 Morningstar Stock Strategist piece said, "My favorite financial ratio is--hands down--return on invested capital or ROIC. I think it is ten times better than [sic] ROA or ROE, and net profit margin doesn't even come close."

That's because, she says, [ROIC] "single-handedy provides a quantitative answer to the question, Does this company have an economic moat? .... [and] Given how great the ROIC metric is, I wish there was a stock screener that would help me find companies with high ROICs, but unfortunately one doesn't exist.....ROIC is a measure of how much cash a company gets back for each dollar it invests..."

She points out these limitations: (1)NET INCOME is used as numerator in both calculations, but, she says there can be many things going on "below the line" that make an unprofitable company appear profitable. (2)ROE:by carrying high debt & repurchasing shares, management can increase leverage & thus ROE,"But either can produce an unreasonably high ROE that doesn't accurately represent the company's profitability." (3)ROA:"...companies can carry lots of assets that have nothing to do with their operations."

And so on. But, AAII, how about creating the missing ROIC screen?

AAII: How about creating an ROIC screen?


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